When the business can invest at incremental returns that are enticing
Growth comes into the equation twice for (value) investors. First, to estimate fair value. Second, unless a company is capable of significant growth there is no point investing in it.
So, the topic of this post is ‘Growth for (value) investors’. I might have titled it: ‘how and when (value) investors need to think about growth’.
Just call it ‘investing’
Let me state as clearly and simply as possible what I see as Warren Buffett’s approach to investing. I am repeating here what I have written before. His style reflects his investing aims, which are, very simply to: “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham.1998) p93.
His style is thus to identify companies that achieve that end and buy them at ‘a very attractive’ price. (Buffett, 1998) p85. Note, he does not require that they march steadily upward. There is a normal lumpiness to the earnings of even the best companies. The only earnings that grow steadily are those that are ‘managed’ by the CEO and CFO. The ‘very attractive price’ is to provide a margin of safety.
The first thing I would note is that this is a recipe for investing in growth (growth investing?) Is Warren Buffett a value investor or a growth investor? It is often said that Warren Buffett learned his investing from Ben Graham. That is only partly true. He learned about ‘Mr. Market’ and margin of safety from Ben Graham. But, the type of company to invest in he learned from Philip Fisher. Ben Graham’s best known style of investing is described by Warren Buffett as cigar butt investing. You find a cigar butt on the ground for free and get a few free puffs out of it. That style has little to do with what Buffett has done in the last fifty years.
Warren Buffett is reported by The Economist magazine in its February 2, 2013 edition to have said: “Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”
For readers wishing to read more deeply about Warren Buffett’s investment style, take a look at my post Misconceptions about Warren Buffett’s approach to investing
We should really do away with the terms ‘value investing’ and ‘growth investing’ and just call it investing.
Growth for valuation purposes
The forgoing sets the scene for our discussion of how growth comes into the equation twice for (value) investors. As I noted in my earlier post referred to above, in discussing the two customary approaches to investing, ‘value’ and ‘growth’, Buffett confesses to earlier fuzzy thinking and says:
“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett, 1998) p85. (emphasis added)
The proper way to value stocks is the use of discounted cash flow analysis. Assumptions are made about years of future cash flows and those dollar amounts are discounted back to the present to come up with an estimate of fair value today. For readers wishing to learn more about DCF see my post The dangers and benefits of using Discounted Cash Flow analysis reports
The key thing to note for present purposes is that a higher assumption of future growth will result in a higher estimate of fair value today. This is what Buffett means when he says ‘growth is always a component in the calculation of value’.
Without growth there is no point investing
I started this post by saying growth comes into the equation twice. We have just seen that growth is an essential component of calculating fair value.
But, it doesn’t matter how cheap a stock is in relation to fair value, if it is not capable of significant growth there is no point investing in it. As quoted above, our object is: “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
How to identify stocks capable of significant growth
We now come to the heart of it. I can do no better than quote Shakespeare:
“If you can look into the seeds of time,
And say which grain will grow and which will not,
Speak then to me.”
– Macbeth, Act 1, Scene 3
This topic is all about skill in stock picking. One way some investors approach the challenge is to pick stocks that are household name companies with big profitable franchises that have grown over the previous ten years and assume growth will continue. I believe there is a lot more to it and there are many pitfalls. Some of these businesses may even generate excess capital. The problem is that they may not have profitable ways to deploy this capital. Warren Buffett says that it is more about business analysis than stock analysis.
In essence: “Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett, 1998) p86. (emphasis added) To read more about this see my post: The best approach to choosing common stocks
I must confess that for a long time I focused on stocks generating significant free cash flow without paying enough attention to how they would invest that excess capital at ‘enticing returns’. I sold a stock this spring that was regularly producing Returns on Invested Capital north of 20%. Its ROIC numbers weren’t distorted by the company having a lot of intangible assets not reflected on the balance sheet. (On this issue see my posts: return on invested capital and return on equity )
It was a very profitable company, but the company just didn’t have many opportunities to reinvest the free cash flow in profitable endeavours.
Conclusion
Whether they think of themselves as value investors, growth investors or just ‘investors’ everyone needs to thing about the potential for growth of companies they invest in. It impacts value assessments. It is also critical in deciding which stocks to invest in.
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Here are some related posts I have published previously:
The under-performance of value stocks explained
Heart of stock valuation: subtleties of free cash flow
Stock valuation in an age of intangible assets
How Warren Buffett goes about valuing companies
Do investors need to identify and invest in future FAAMGN stocks?
The false dichotomy between ‘value stocks’ and ‘growth stocks’
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You can reach me by email at rodney@investingmotherlode.com
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